Monday, October 29, 2007

UK Economy: Low unemployment and inflation

Q. Examine the factors which might explain the UK’s low inflation and low unemployment of recent years (60)

The UK has experienced a fall in unemployment from 3 million in 1992 to under 1 million in 2007. Inflation has also remained very low. Since 1997, CPI inflation has remained close to the government's target of 2% +/-1

The first factor to explain the fall in unemployment is economic growth. The UK has experienced a long period of uninterrupted economic growth since 1992. Growth has averaged 2.6% which is close to the long run trend rate of growth. This economic growth creates increased output and therefore firms employ more workers; this means cyclical unemployment is very low. Economic growth is one of the most significant factors for low unemployment in the UK, this is because when the UK experienced a recession in 1992, unemployment increased to 3 million.

Economic growth often causes inflation, because as the economy approaches full capacity, prices start to rise. However, in the case of the UK this has not occurred. Inflation has remained low because economic growth has remained steady and sustainable. Growth has never been much higher than the long run trend rate (2.5%). Therefore, growth has been non inflationary. This steady rate of economic growth is a significant factor in maintaining low inflation, if the growth was too fast then inflation would occur.

Many give credit to the MPC for these relatively benign economic conditions. The MPC have independence in setting interest rates; when inflationary pressures increase they respond by raising interest rates. Therefore, this has helped to keep inflation low and growth positive. The MPC have also helped reduce inflationary expectations because people have confidence in them. This has increased their effectiveness.

However, aggregate demand cannot alone explain low unemployment and low inflation. The low inflation in a period of economic growth suggests there are supply side factors helping to maintain low inflation. For example, increased productivity in the economy is keeping costs low; new technologies such as the internet and micro computers are helping to reduce costs for many firms. It is difficult to quantify the effects of this on inflation. However, for many electrical goods we can see falling prices, therefore it is important for some goods.

Global factors are also important, low inflation is not just a UK phenomena. Low inflation has occured in most of the OECD economic countries. This is related to the competitive effects of globalisation and lower raw material prices. However, in the EU, the low inflation has not been matched by low unemployment. The EU has higher unemployment than the UK, this suggests that the UK has benefited from better supply side policies.

For example, it is argued that UK labour markets are relatively flexible. In recent years the power of trades unions has fallen and it is easier to hire and fire workers than in the EU. This helps to explain the lower natural rate of unemployment and low inflation in the UK. However, it is worth remembering that the UK still has a high minimum wage, and some labour market restrictions, therefore it is difficult to quantify the true effects of these supply side factors.